DEALING WITH IRS: AUDITS AND OTHER ISSUES
Presented By
DAVID D. AUGHTRY
CHAMBERLAIN, HRDLICKA, WHITE, WILLIAMS & AUGTHRY
e-mail: david.aughtry@chamberlainlaw.com
Thirty-Fourth Floor
191 Peachtree Street N.E.
Atlanta, Georgia 30303-1747
(404) 659-1410
Suite 1400
1200 Smith Street
Houston, Texas 77002-4310
(713) 658-1818
© Copyright, Chamberlain, Hrdlicka, White, Williams & Aughtry, 2007
Suite 570
300 Conshohocken State Rd.
West Conshohocken, PA 19428
(610) 772-2300
ABOUT THE SPEAKER
DAVID D. AUGHTRY
David is the managing partner in the Atlanta Office of Chamberlain, Hrdlicka, White, Williams
& Aughtry. He practices in the area of civil and criminal tax litigation. Unable to attend a
normal college, David graduated from the Citadel with a degree in English (taught as a second
language) in 1975. He then graduated from the University of South Carolina with a Masters in
Accountancy and a law degree in 1978, and from Emory with a Masters in Taxation (L.LM.) in
1982. He taught tax controversy as an Adjunct Professor at Emory University School of Law
(1987-93, 1997-98, 2003), and has served as an instructor for the National Institute for Trial
Advocacy, ALitigating Before The United States Tax Court@ program from 1993 through 2001.
He is a Fellow in the International Society of Barristers. In his prior life, he served as the Tax
Shelter Coordinator and Trial Attorney for the Office of Chief Counsel, Internal Revenue Service
(1978-82). He has tried (and/or argued on appeal) over 70 cases and successfully argued Hubert
v. Commissioner before the Tax Court, the Eleventh Circuit, and the Supreme Court. David was
Chairman of the Budget and Investment Committees of the State Bar of Georgia (1987-1993),
and currently serves on the Board of Trustees of the Southern Federal Tax Institute.
For further information, please contact www.chamberlainlaw.com
TABLE OF CONTENTS
Page
I.
RECENT DEVELOPMENTS HAVE CHANGED THE LANDSCAPE FOR
TAXPAYERS AND THEIR REPRESENTATIVES ......................................................... 1
A.
Simultaneous Civil and Criminal Cases ................................................................. 1
1.
The Wall Between Civil and Criminal Investigations ................................ 1
2.
The Wall Begins to Crumble ...................................................................... 2
3.
Wall? What Wall? ...................................................................................... 3
B.
Fraud Referrals Specialists ..................................................................................... 6
1.
Avoidance of Tweel .................................................................................... 6
2.
Result .......................................................................................................... 6
C.
Recent Case Law..................................................................................................... 6
1.
United States v. Stringer, 408 F.Supp.2d 1183 (D. Oregon 2006) ............. 6
2.
United States v. Scrushy, 366 F.Supp.2d 1134 (N.D. Ala. 2005) ............... 7
3.
United States v. Posada Carilles, 486 F. Supp. 2d 599 (W.D. Tex.
2007) ................................................................... …………………………7
D.
Preparer Penalty Exposure………………………………………………………...7
1.
Section 6694 Preparer Penalties…………………………………………...7
2.
Circular 230 and Related Conflict Considerations………………………..9
II.
COUNSEL MUST BE ACUTELY AWARE OF POTENTIAL CRIMINAL
ISSUES DURING CIVIL EXAMINATIONS ................................................................. 11
A.
What Is an Eggshell Audit? .................................................................................. 11
1.
Eggshell Audits Can Lead to Criminal Charges ....................................... 11
2.
Cooperation or Silence .............................................................................. 11
3.
Cooperation Must Be Truthful .................................................................. 11
4.
Perils for the Representative ..................................................................... 11
5.
Potential Outcomes ................................................................................... 11
B.
Sources of Criminal Cases .................................................................................... 12
1.
Informants ................................................................................................. 12
2.
Undercover Activities ............................................................................... 12
3.
Civil Audits ............................................................................................... 12
4.
Independent Criminal Investigations ........................................................ 12
5.
Agency Referrals ...................................................................................... 12
6.
Monitoring and Matching Programs ......................................................... 12
C.
Signs of a Criminal Referral ................................................................................. 12
1.
Surprises Abound ...................................................................................... 12
2.
Ask and You Might Receive ..................................................................... 14
III.
CONTROLLING AND ADVISING THE CLIENT ........................................................ 14
A.
Communicating the Priorities ............................................................................... 14
1.
Primary Goal ............................................................................................. 14
2.
Secondary Goal ......................................................................................... 14
B.
Evidence and Document Control .......................................................................... 14
1.
The Client’s Right to Remain Silent ......................................................... 14
-i-
2.
3.
4.
IV.
Advise the Taxpayer Against Tampering with Evidence or Talking
with Witnesses .......................................................................................... 14
Conduct a Shadow Investigation .............................................................. 15
Public Documents ..................................................................................... 15
DEALING WITH THE AGENT ...................................................................................... 16
A.
Who Should Handle the Exam? ............................................................................ 16
1.
The Problem .............................................................................................. 16
2.
The Choices .............................................................................................. 16
3.
Issues to Consider ..................................................................................... 16
B.
The Accountant’s Roles ........................................................................................ 17
1.
Defining the Different “Hats” ................................................................... 17
2.
Protect Communications and Work Product............................................. 18
C.
Accountant/Client Privilege Issues ....................................................................... 18
1.
New Protection for Certain Communications ........................................... 18
2.
Matters Covered ........................................................................................ 18
3.
Federally Authorized Tax Practitioner...................................................... 19
4.
Effective Date ........................................................................................... 19
5.
Obvious Limitations of Section 7525 ....................................................... 19
6.
Civil v. Criminal ....................................................................................... 21
7.
Business Advice v. Tax Advice ................................................................ 22
D.
Recommendations to Seek to Bolster Kovel Accountant Privileges .................... 22
1.
Burden ....................................................................................................... 22
2.
Documentation .......................................................................................... 22
3.
Avoid Multiple Roles................................................................................ 22
4.
Execute a Contract .................................................................................... 23
5.
Protect Work Product ................................................................................ 23
E.
Cooperation ........................................................................................................... 23
1.
The Dilemma ............................................................................................ 23
2.
Burden of Proof Considerations................................................................ 23
3.
Non-Cooperation as a Badge of Fraud...................................................... 24
4.
Sentencing Guidelines Considerations ..................................................... 25
F.
Access to the Taxpayer ......................................................................................... 25
1.
Resisting the Taxpayer Interview ............................................................. 25
2.
Controlling the Taxpayer Interview .......................................................... 25
3.
Refusing the Taxpayer Interview .............................................................. 26
4.
Economic Reality Audits .......................................................................... 26
G.
Records Control .................................................................................................... 26
1.
Shadow Investigation ................................................................................ 26
2.
Playing Catch-Up ...................................................................................... 27
3.
Third Party Documents ............................................................................. 27
4.
Follow the Leads ....................................................................................... 27
5.
Protect Privileged Documents................................................................... 27
H.
Notice of Third Party Contacts ............................................................................. 28
1.
Section 7602(c) ......................................................................................... 28
2.
No Remedy ............................................................................................... 28
-ii-
V.
HANDLING THE CURRENT YEAR OR DELINQUENT RETURNS ......................... 28
A.
Consider Voluntary Disclosure ............................................................................. 28
1.
Voluntary Disclosure Practice .................................................................. 28
2.
Foreign Bank Accounts............................................................................. 28
3.
Solicitation Policy ..................................................................................... 28
B.
Filing The Current Year Return ............................................................................ 29
1.
Tax Returns Filed During an Investigation ............................................... 29
2.
Extensions ................................................................................................. 29
3.
Asserting the Fifth Amendment Privilege on Tax Returns ....................... 29
4.
Cash Bonds ............................................................................................... 33
5.
Payments v. Deposits ................................................................................ 33
-iii-
DEALING WITH IRS: AUDITS AND OTHERS ISSUES
Presented By
DAVID D. AUGHTRY
I.
RECENT DEVELOPMENTS HAVE CHANGED THE LANDSCAPE FOR
TAXPAYERS AND THEIR REPRESENTATIVES.
A.
Simultaneous Civil and Criminal Cases. Recent events have shown that the
IRS and the Tax Division of the Justice Department is now more prone to conduct
civil examinations of taxpayers while simultaneously pursuing criminal
investigations.
1.
The Wall Between Civil and Criminal Investigations. The general
practice historically has been to suspend a civil examination once a
criminal investigation of the taxpayer had begun. Delay of the civil case
protects the integrity of the criminal investigation and avoids
complications in the criminal case. As set forth in the Internal Revenue
Manual, there was a wall between criminal and civil investigations:
(1) If, during an examination, an examiner uncovers a
potentially fraudulent situation caused by the taxpayer and
or the preparer, the examiner shall discuss the case at the
earliest possible convenience with his/her group manager.
*
*
*
Once there is a firm indication of criminal fraud, all
examination activity shall be suspended.
Internal Revenue Manual § 4565.21(1) (07-01-1996).
A firm indication of fraud must be distinguished from a
first indication of fraud. A firm indication of fraud is a
factual determination that can only be made on a case by
case basis. An examiner who is in doubt should consult
with the manager and the FRS to determine if the indicators
of fraud are sufficiently developed. However, under no
circumstances shall examiners or managers obtain advice
and/or direction from Criminal Investigation for a specific
case that is under examination.
*
*
*
If an examiner discovers firm indications of fraud, the
examination should immediately be suspended without
disclosing to the taxpayer the reason for such suspension.
Examiners are cautioned not to carry the investigation
beyond the point where a valid indication of fraud is
adequately supported by the workpapers.
Internal Revenue Manual (IRM) § 4.23.9.6.2 (03-01-2003).
The wall existed because the IRS once recognized that it should
not deceive taxpayers. In United States v. Tweel, 550 F.2d 297 (5th Cir.
1977), the Revenue Agent was asked by the taxpayer’s representative if a
Special Agent was involved. The Revenue Agent responded that there
was no Special Agent involved. The Court later found such response
intentionally misleading.
[W]e find that the agent’s failure to apprise the [taxpayer]
of the obvious criminal nature of this investigation was a
sneaky deliberate deception by the agent . . . . The silent
misrepresentation was both intentionally misleading and
material.
*
*
*
We cannot condone this shocking conduct by the IRS. Our
revenue system is based upon the good faith of the
taxpayers and the taxpayers should be able to expect the
same from the government in its enforcement and
collection activities.”
United States v. Tweel, 550 F.2d 297, 299-300 (5th Cir. 1977)
2.
The Wall Begins to Crumble. Over the past several years, the spate of
corporate scandals and the threat of the burgeoning corporate tax shelter
industry caused the IRS and the Justice Department to rethink the strategy
of suspending civil examinations during criminal investigations. In a
number of high profile recent cases, civil examinations have proceeded
simultaneously with criminal investigations, including such notorious
matters as the Enron Task Force and the KPMG grand jury investigation.
In 2004, the IRS began adding vague and soft language to the
Internal Revenue Manuel which began further eroded the wall between
criminal and civil investigations.
The criminal and civil aspects of a case do not present an
either/or proposition. Rather, the criminal and civil aspects
of a case should be balanced to the extent possible without
prejudicing the criminal prosecution.
2
1393345.1
IRM § 38.3.1.8 (08-11-2004)
3.
Wall? What Wall?
a.
The Wall is Gone. In 2007, the IRS revised its policies yet again,
and this time the IRS completely obliterated the wall that once
existed between criminal and civil tax investigations:
1. The Internal Revenue Code (IRC)
contains both civil and criminal provisions to
address fraud. Revenue officers may conduct civil
investigations before, during or after criminal
investigations of the same taxpayer. If the
investigation is conducted simultaneously with the
criminal investigation, the process is referred to as a
parallel investigation.
*
*
*
3. Parallel
proceedings
involve
simultaneous investigations or litigations of
separate civil and criminal aspects of a case
involving a common individual or entity. Some
potential civil remedies that could occur in a
parallel proceeding are IRC 6672 Trust Fund
Recovery Penalty Investigations, injunctions for
pyramiding taxpayers, Notice of Federal Tax Lien
filings, issuance of levies, jeopardy levies, service
of summons, and pursuit of erroneous refunds.
4. Civil
and
criminal
parallel
investigations
are conducted as
separate
investigations. They are not joint investigations but
do require significant coordination between the
Operating Divisions throughout the civil
investigation and litigation processes. While
regularly scheduled coordination meetings are
required, CI must not direct the revenue officer’s
actions in the civil investigation.
IRM § 5.1.5.1(4) (01-01-2007) (emphasis added).
3
1393345.1
b.
Criminal and Civil Investigators Must Communicate and
Coordinate. “Parallel”
investigations
require
significant
coordination and communication between Special Agents and
Revenue Officers:
1. Once agreement is reached that a
parallel investigation will take place, criminal
investigators and revenue officers conducting the
parallel investigation should coordinate the
development of the evidence that will support both
the criminal and civil actions while being mindful
of the legal requirements and constraints.
2. Ongoing communication is essential for a
successful parallel investigation.
IRM § 5.1.5.4 (01-01-2007)
1. A coordination meeting must take place
within 30 days of the decision approving the
parallel investigation. The participants must include
the Revenue Officer, Special Agent, their respective
managers and SBSE Area Counsel and criminal tax
attorneys. The local Fraud Technical Analyst (FTA)
should also be consulted. If a matter has been
referred to DOJ/USAO, DOJ/USAO attorneys
should be included in coordination activities.
2. Civil and criminal investigators and
IRS attorneys should continually coordinate their
efforts. Case status meetings should be held at least
quarterly until the collection actions are complete.
These coordination meetings will facilitate sharing
important case developments.
3. The purpose of the case status meeting
is to communicate the case developments and
facilitate information sharing between Collection
and CI. In grand jury cases, CI will not be able to
share information subject to grand jury secrecy
rules and IRC disclosure provisions. The revenue
officer should be prepared to discuss the collection
plan of action and the impact of these actions on the
criminal proceeding. CI will not direct the actions in
the collection investigation.
IRM § 5.1.5.5 (01-01-2007)
4
1393345.1
c.
Criminal and Civil Investigators Must Share Information.
“Parallel” investigations require Special Agents and Revenue
Agents to share information.
1. Sharing information between revenue
officers and government attorneys assigned to the
case is a key ingredient in developing civil and
criminal cases simultaneously and efficiently.
*
*
*
5. Revenue officers must inform CI that
civil files are available. Access to all available
information in the civil file must be provided to CI.
Criminal attorneys have a duty to disclose certain
information to criminal defendants; therefore, it is
absolutely necessary for the special agents and
criminal attorneys to be made aware of and
provided with all the information in the collection
file, including documents, interview notes and any
other information that SBSE gathers. The sharing of
information should be done so that there are no
unnecessary delays.
IRM § 5.1.5.8 (01-01-2007)
d.
The Taxpayer Must Not be Advised of the Criminal
Investigation. Per IRS policy, the Revenue Agent is not allowed
to tell the taxpayer that there is a “parallel” criminal investigation
underway.
1. The revenue officer will advise the
special agent assigned to the parallel investigation
of all meetings with the taxpayer(s).
*
*
*
3. If a taxpayer under investigation
inquires about criminal implications or whether
the taxpayer is the subject of a criminal
investigation before CI has contacted the taxpayer,
the revenue officer must be careful to provide
accurate information and not mislead the
taxpayer. The revenue officer should inform the
taxpayer that they are conducting a civil
investigation, and that the information obtained can
be shared with Criminal Investigation. Under no
5
1393345.1
circumstances should the revenue officer inform
the taxpayer that the case has been referred to
Criminal Investigation (CI). This is CI’s
responsibility. The revenue officer should
immediately notify the special agent of the contact
with the taxpayer.
IRM § 5.1.5.6 (01-01-2007)
B.
C.
Fraud Referrals Specialists. The IRS has increased the use of fraud referral
specialists, who are posted throughout the United States and attached to
examination and collection groups. The purpose of fraud referral specialists is to
assist revenue agents and revenue officers with case development. Anecdotal
evidence reflects an increase in the imposition of civil fraud penalties and referral
of cases to the Criminal Investigation Division.
1.
Avoidance of Tweel. The IRS view is that use of a fraud referral
specialist avoids the harm that concerned the Fifth Circuit in the Tweel
case, that a taxpayer could be intentionally misled as to the civil nature of
an examination when in fact a criminal investigator (special agent) was
actually pulling the strings of the examination.
2.
Result. Essentially, the IRS has created a new level of criminal
investigations, but inserted it within the examination and collection
functions in order to avoid the appearance that a special agent was
directing the inquiry. Thus, the Service conducts potential examinations
and collection actions while gathering information to bolster a criminal
case. The “firm indication of fraud” standard, while nominally within IRS
training materials, is now essentially ignored by the agents and often by
case law.
Recent Case Law. Recent cases demonstrate how the Courts are likely to
evaluate the new IRS policies regarding parallel investigations:
1.
United States v. Stringer, 408 F.Supp.2d 1183 (D. Oregon 2006). The
civil and criminal investigators communicated regularly throughout the
civil investigation, exchanging information and discussing strategy.
Response to direct question about criminal investigation was evasive and
misleading.
. . . but the District Court was reversed:
United States v. Stringer, 535 F.3d 929 (9th Cir. 2008). The Ninth Circuit
held that the United States did not violate defendants’ Fifth Amendment
privilege against self-incrimination due to Securities and Exchange
Commission (SEC) attorneys’ failure to inform defendants during civil
enforcement action that United States Attorney’s office had opened
6
1393345.1
criminal investigation against them, where SEC alerted defendants that
any information they provided could be used in criminal proceeding,
defendants were represented by counsel, and SEC warned each defendant
at beginning of each deposition that “facts developed in this investigation
might constitute violations of criminal laws.”
2.
United States v. Scrushy, 366 F.Supp.2d 1134 (N.D. Ala. 2005).
Government manipulated simultaneous criminal and civil investigations.
Investigations were not longer parallel, but were commingled and thus
improper. “Our justice system cannot function properly in the face of
such cloak and dagger activities by those charged with upholding the
integrity of the justice system.”
3.
United States v. Posada Carilles, 486 F. Supp. 2d 599 (W.D. Tex. 2007).
The U.S. District Court for the Western District of Texas dismissed the
entire indictment against a criminal defendant, concluding that the
government had improperly used the defendant’s civil naturalization
interview solely for the purpose of gathering evidence for the criminal
proceeding.
. . . but the District Court was reversed:
United States v. Posada Carriles, 541 F.3d 344, 356 (5th Cir. 2008). The
Fifth Circuit held that the Government did not engage in fraud, trickery,
and deceit or outrageous conduct in conducting naturalization interview of
defendant even though the immigration agent who conducted interview
had already determined that the defendant was likely not eligible for
naturalization and had met with attorneys from the Department of Justice
and the Department of Homeland Security prior to the interview, in part
because the defendant was warned at the beginning of interview that he
could exercise his right against self-incrimination, was warned that any
statement he gave could be used in any legal or administrative proceeding,
and the defendant, not the government, triggered the process that called
for an investigation and an interview by filing his naturalization
application.
D.
Preparer Penalty Exposure.
1.
Section 6694 Preparer Penalties.
a.
Preparers subject to Section 6694. A preparer is any person who
prepares for compensation, or who employs one or more persons to
prepare for compensation, all or a substantial portion of any return
of tax or any claim for refund of tax under the code. Treas. Reg. §
301.7701-15(a). A person who furnishes to a taxpayer or other tax
return preparer sufficient information and advice so that
completion of the return or claim for refund is largely a mechanical
7
1393345.1
or clerical matter is also considered a return preparer even though
that person does not actually place or review placement of
information on the return or claim for refund. Treas. Reg. §
301.7701-15(c).
b.
Section 6694 applies to both signing preparers and nonsigning
preparers.
A signing preparer is the preparer who has the
primary responsibility for the overall substantive accuracy of the
preparation of the return or claim for refund. Treas. Reg. §
301.7701-15(b)(1). A nonsigning preparer is any preparer who is
not a signing preparer but who prepares all or a substantial portion
of a return or claim for refund with respect to events that have
occurred when the advice is rendered. Treas. Reg. § 301.770115(b)(2)(i).
c.
Penalties imposed for understatement due to unreasonable
positions. Effective May 25, 2007, the Small Business and Work
Opportunity Act of 2007 (SBWOA) amended section 6694(a) to
require that return preparers meet a more likely than not standard
for their statements to the Service or disclose the transactions
underlying their statements. The clients, however, had no such
duty.
Effective October 3, 2008, the Tax Extenders and
Alternative Minimum Tax Relief Act of 2008 modified the
SBWOA amendments to section 6694(a). The definition of a
reasonable position (that is, conduct not subject to the penalty) is
now divided into three separate tiers, each with its own standard to
determine whether the position set forth in the return is an
unreasonable position.
1. Disclosed Positions. For disclosed positions, the
section 6694(a) penalty applies unless there is or was a reasonable
basis for the position set forth in the return. This standard applies
to returns prepared after May 25, 2007. See Notice 2009-5.
2. Undisclosed Positions For undisclosed position, the
section 6694(a) penalty applies unless there is or was substantial
authority for the position set forth in the return. This standard
applies to returns prepared after May 25, 2007. See Notice 2009-5.
There is substantial authority for the tax treatment of an item (1) if
the weight of authorities supporting the treatment is substantial in
relation to the weight of authorities supporting contrary treatment
or (2) the taxpayer is the subject of a written determination as
provided in Treas. Reg. § 1.6662-3(b)(3).
3. Tax Shelters. The section 6694(a) penalty generally
applies in the case of tax shelters as defined in section
6662(d)(2)(C)(ii) as well as reportable transactions to which
8
1393345.1
section 6662A applies unless there is or was a reasonable belief
that the position set forth in the return would more likely than not
be sustained on the merits. A position for a tax shelter will not be
deemed an unreasonable position for purposes of section 6694(a) if
there is substantial authority for the position and the preparer
advises the taxpayer of the penalty standards applicable to the
taxpayer if the transaction is deemed to have a significant purpose
of federal tax avoidance or evasion. See Notice 2009-5.
d.
2.
Penalties imposed for understatement due to willful or reckless
conduct. A return preparer is not considered to have recklessly or
intentionally disregarded a rule or regulation in violation of section
6694(b) if the position contrary to the rule or regulation has a
reasonable basis as defined in Treas. Reg. § 1.6694-2(d)(2) and is
adequately disclosed. Treas. Reg. § 1.6694-3(c)(2). A position
contrary to the regulation must represent a good-faith challenge to
the validity of the regulation. Further, the return preparer must
identify the regulation being challenged at the time the position is
properly disclosed. A position contrary to a published revenue
ruling or IRS notice is not considered reckless or an intentional
disregard of the rules where the preparer reasonably believes that
the position meets the substantial authority standard of Treas. Reg.
§ 1.6662-4(d). Treas. Reg. § 1.6694-3(c)(3).
Circular 230 and Related Conflict Considerations.
a.
Circular 230 (31 CFR Part 10) prohibits a practitioner from
representing a client before the IRS if the representation involves a
conflict of interest.
b.
A conflict of interest exists under Circular 230 section 10.29(a) if
(1) representation of one client would be directly adverse to
another client or (2) there is a significant risk that the
representation of one or more clients will be materially limited by
the practitioner's responsibilities to another client, a former client
or a third person or by a personal interest of the practitioner.
c.
The American Institute of Certified Public Accountants (AICPA)
Code of Professional Conduct, as adopted January 12, 1988,
amended January 14, 1992 and October 28, 1997, similarly
prohibits the professional engagement where a conflict exists.
d.
AICPA, ET Section 55, Article IV – Objectivity and Independence
provides:
A member should maintain objectivity and be free of conflicts of
interest in discharging professional responsibilities. A member in
9
1393345.1
public practice should be independent in fact and appearance
when providing auditing and other attestation services.
e.
AICPA, ET Section 102 provides:
Integrity and objectivity. In the performance of any professional
service, a member shall maintain objectivity and integrity, shall be
free of conflicts of interest, and shall not knowingly misrepresent
facts or subordinate his or her judgment to others.
f.
Interpretations of situations where conflicts may exist under
AICPA Rule 102:
A member has provided tax or personal financial planning
(PFP) services for a married couple who are undergoing a divorce,
and the member has been asked to provide the services for both
parties during the divorce proceedings.
A member has been asked to perform litigation services for
the plaintiff in connection with a lawsuit filed against a client of
the member's firm.
In connection with a PFP engagement, a member plans to
suggest that the client invest in a business in which he or she has a
financial interest.
A member provides tax or PFP services for several
members of a family who may have opposing interests.
A member has a significant financial interest, is a member
of management, or is in a position of influence in a company that is
a major competitor of a client for which the member performs
management consulting services.
A member serves on a city's board of tax appeals, which
considers matters involving several of the member's tax clients.
A member has been approached to provide services in
connection with the purchase of real estate from a client of the
member's firm.
A member refers a PFP or tax client to an insurance broker
or other service provider, which refers clients to the member under
an exclusive arrangement to do so.
10
1393345.1
II.
COUNSEL MUST BE ACUTELY AWARE OF POTENTIAL CRIMINAL ISSUES
DURING CIVIL EXAMINATIONS.
A.
What Is an Eggshell Audit?
1.
Eggshell Audits Can Lead to Criminal Charges. An “eggshell” audit
arises when a taxpayer who has filed one or more false returns in previous
years is selected for audit. Although the exam is a civil one, it has the
potential for criminal referral.
2.
Cooperation or Silence. The taxpayer must decide whether to assert his
Fifth Amendment privilege (including the Fifth Amendment act of
production privilege) or voluntarily supply information to the revenue
agent which may be later deemed a waiver of the taxpayer’s Fifth
Amendment privilege. See United States v. Kordel, 397 U.S. 1 (1970).
3.
Cooperation Must Be Truthful. If the taxpayer does not assert his Fifth
Amendment privilege, vigilance must be exercised to avoid supplying
false information that could result in obstruction charges in addition to any
criminal tax charges. Once an attorney makes representations to the IRS
under a Form 2848, those statements may be used against the client at
trial. Statements made to third parties are generally no longer protected by
the attorney-client privilege. See, e.g., United States v. Pappas, 806 F.
Supp. 1, 2-5 (D.N.H. 1992).
4.
Perils for the Representative. The taxpayer’s representative in an
eggshell audit must also be careful not to do anything the government may
deem to be criminal under either I.R.C. § 7206(2) or I.R.C. § 7212.
5.
a.
I.R.C. § 7206(2) criminalizes aiding or assisting in the presentation
or preparation of a false or fraudulent document. The government
will bring such a charge if the government believes the
representative assisted, counseled, or advised the client to present a
document knowing that the document may be false as to a material
matter.
b.
I.R.C. § 7212 makes it a criminal offense to attempt to interfere
with the administration of the Internal Revenue laws. The
government will bring such a charge if the government believes the
taxpayer’s representative corruptly endeavored to obstruct or
impede the due administration of the Internal Revenue laws.
Potential Outcomes. There are three potential outcomes in an eggshell
audit.
a.
1393345.1
The auditor may never notice the criminal problem in the return
and thus the taxpayer is never presented with the dilemma of
responding to that issue.
11
B.
C.
b.
The auditor may spot the sensitive issue, but the taxpayer’s
representative is able to convince the auditor that the case is best
resolved civilly and that the taxpayer’s conduct does not warrant a
criminal investigation or prosecution. The role of the unseen
Fraud Referral Specialist must be considered at every step.
c.
The auditor may make a criminal referral. In this situation, the
taxpayer’s representative must make sure that the taxpayer does
not do anything during the course of the investigation to worsen
his position.
Sources of Criminal Cases.
1.
Informants. Tipsters and other third parties, such as ex-wives or
disgruntled employees provide a wealth of information to the Criminal
Investigation Division. Many of these tipsters are motivated by revenge or
a desire to seek the reward of up to ten percent of the tax and penalty
ultimately recovered by the Internal Revenue Service. 26 U.S.C. § 7623.
(Only ten percent of those who claim rewards are actually paid.)
2.
Undercover Activities. “Sting” cases such as those involving insurance,
Medicaid fraud, or other types of fraud routinely involve allegations of tax
improprieties.
3.
Civil Audits. Civil audits of related or associated taxpayers often lead to
criminal investigations.
4.
Independent Criminal Investigations. Special agents spend hours
perusing local newspapers, court records, and legal filings for “notorious”
cases with potential tax implications.
5.
Agency Referrals. Police agencies, other federal agencies and grand
juries may also provide information that leads to a criminal tax
investigation.
6.
Monitoring and Matching Programs. Form 8300 transaction reporting
documents (or, more likely, the failure to file the form) may lead to
criminal charges.
Signs of a Criminal Referral.
1.
Surprises Abound. Even experienced tax lawyers are often surprised by
which cases with fraud potential are referred for criminal investigation and
which escape referral. However, certain activities by revenue agents
indicate that a criminal referral is likely to result. The following events
often suggest that the revenue agent may be considering a referral to the
criminal investigation division:
12
1393345.1
a.
Undue Interest. The agent shows an undue amount of interest in
the sensitive transaction.
b.
Excessive Copying. The agent requests large numbers of copies
of documents rather than merely asking to review the documents.
This pattern of behavior is less an indicator than in years past,
because the examination division has increased the amount of
documentation it traditionally makes a part of the administrative
file.
c.
Questions on Intent. The agent poses questions that focus on the
intent of the taxpayer. For example, the agent asks questions
concerning what the taxpayer knew or who gave the instructions to
take certain actions.
d.
Bank Records Analysis. The agent begins examining in great
detail records that can be used to corroborate or impeach items
reported on the return. For example, the agent spends an undue
amount of time reviewing bank records to verify gross receipts, or
the agent starts examining price lists carefully in order to
circumstantially examine whether the taxpayer might have
skimmed gross receipts.
e.
Net Worth Analysis. The agent focuses attention on the balance
sheet of the taxpayer for the beginning and ending of each year.
Again, the examination division now regularly requests and
reviews the taxpayer’s net worth documentation, so this is less an
indicator than in years past. However, it may suggest that the
agent believes that the taxpayer’s return does not adequately reflect
income and may be used as an indirect method of income analysis.
f.
The Disappearing Agent. The agent stops discussing the status of
the audit or disappears. If the agent states that he or she will be
away “in training” for a month or more, this often may be an
excuse to buy time for the criminal referral to be considered by the
criminal investigation division.
13
1393345.1
2.
III.
Ask and You Might Receive. Sometimes the most effective way to
determine whether a criminal referral is likely is to ask the agent directly.
Often, agents will indicate that they do not think fraud is involved despite
grossly erroneous activities. A direct question sometimes will reveal that
the taxpayer need not worry about a criminal referral.
CONTROLLING AND ADVISING THE CLIENT.
A.
B.
Communicating the Priorities.
1.
Primary Goal. The primary goal in an eggshell audit is to prevent a
criminal referral.
2.
Secondary Goal. The secondary goal is to reduce potential adjustments
and tax liability.
Evidence and Document Control. In an eggshell audit, controlling and
monitoring the documents and evidence is of paramount importance and can
mean the difference between containing the audit or a criminal referral.
1.
2.
The Client’s Right to Remain Silent.
a.
The taxpayer should never speak with the revenue agent and if
contacted by the revenue agent should tell the revenue agent that
he or she has retained representation.
b.
Under no circumstances should the taxpayer speak to persons
identifying themselves as special agents. Many educated people
believe they can talk their way out of a criminal case. But it is rare
for clients to successfully explain their actions to special agents
and revenue agents who are bent on a fraud referral. Everything
the clients say can be used against them, especially if they are not
completely truthful, which can bring additional federal charges.
c.
Make sure the taxpayer understands that special agents do not draw
an adverse inference from a taxpayer’s silence. They expect
silence, especially if the taxpayer is represented by an attorney.
Advise the Taxpayer Against Tampering with Evidence or Talking
with Witnesses.
a.
The taxpayer must understand that he or she cannot tamper with
any evidence. If the client tampers with any evidence, backdates
documents, tries to create favorable evidence, or tries to influence
witnesses, he will only make the government’s case easier to
prove.
In addition to obstruction of justice charges, the
government can use the taxpayer’s attempts to tamper with
evidence on the issue of willfulness in a criminal tax prosecution.
14
1393345.1
b.
3.
4.
The taxpayer should also be cautioned against discussing his tax
problems with third parties. Any third party, including a spouse,
can become a witness for the government. In many cases, third
parties who have been contacted by the Internal Revenue Service
contact the taxpayer to tell him about that contact. The taxpayer
should advise these third parties to contact his attorney to discuss
the government’s contact with him.
Conduct a Shadow Investigation. If the taxpayer’s representatives are
new to a civil audit with criminal referral possibilities, they must conduct
a shadow investigation in order to determine the direction in which the
audit is headed and how much government agents know. Some of the
steps they can take to determine what the government already knows are
to do the following:
a.
File a Freedom of Information Act request (FOIA).
b.
If the taxpayer has left any documents with third parties such as a
former accountant, the taxpayer should consider securing the
return of those documents in order to set up a potential Fifth
Amendment privilege claim with respect to these documents.
c.
Copy any documents that third parties have provided to the
government.
d.
Order account transcripts through the IRS Practitioner’s Hotline or
Form 4056.
e.
Interview any witnesses with whom the government has already
spoken regarding the taxpayer’s audit to determine what
information the government already has in its possession.
f.
If, after a review of all the information, the taxpayer’s
representatives determine the government has sufficient
information to calculate a deficiency under any method of proof,
the accountant must do the same analysis to determine any
discrepancies and discover any potential defenses.
Public Documents. High profile, public investigations by Congress or
other investigative agencies may provide documents that can be used
effectively in a civil examination even if a criminal case is simultaneously
underway.
15
1393345.1
IV.
DEALING WITH THE AGENT.
A.
Who Should Handle the Exam?
1.
The Problem. Many accountants are comfortable handling examinations
and other tax controversy matters. However, when the examination will
involve overtones of fraudulent or false statements, the taxpayer and the
accountant often will prefer that an attorney handle the examination.
2.
The Choices. There are several different methods for handling sensitive
examination matters:
3.
a.
The return preparer can appear and represent the client in the
examination;
b.
A new accountant, who specializes in tax controversy matters can
take over for the client;
c.
An attorney who specializes in tax controversy matters can appear
and handle the examination; or
d.
The attorney can use an accountant to “front” the examination with
the attorney in the background providing strategy and advice.
Issues to Consider. Here are some of the factors to consider in deciding
who should represent the taxpayer at the examination stage:
a.
b.
Do not compromise the return preparer’s position as witness.
(i)
If the return preparer has knowledge of the problem areas,
the return preparer will be required to reveal them or
invoke the tax practitioner privilege, which would highlight
the problem areas.
(ii)
If the preparer honestly does not have any knowledge of the
problems and has never discussed them with the client, the
return preparer may be free to handle the examination
without compromising the preparer’s position.
Do not mislead the revenue agent.
(i)
If the return preparer will make affirmative statements
about facts that affirmatively mislead the examining agent,
then this can be extremely dangerous.
(ii)
If the client has made statements to the return preparer that
are false or misleading and the return preparer is likely to
16
1393345.1
repeat those statements, then the return preparer must not
be the one to handle the examination.
B.
Once the examination has begun, changing representatives in
midstream may alert the revenue agent to the possible existence of
fraud.
d.
If the examining agent has already made serious allegations,
discovered the sensitive areas, or otherwise indicated that fraud is
suspected, then bringing an attorney with criminal tax experience
into the examination will be no surprise to the revenue agent.
Rather than confirming the agent’s suspicions, the attorney often
will be able to explain matters in a way that eliminates the
sensitive nature of the inquiries.
e.
Document requests may force your hand. If the examining agent
has requested production of sensitive documents then the client
may need to invoke the Fifth Amendment, or if a summons is
pending, then it is almost expected that an attorney will handle the
examination from that point forward.
The Accountant’s Roles.
1.
1393345.1
c.
Defining the Different “Hats”. Accountants play many different roles in
the course of handling a taxpayer’s affairs, and in an eggshell audit each of
those roles may sometimes need to be played by different individuals.
The various roles include:
a.
Bookkeeping. Often an accountant or enrolled agent is the one
who records the client’s transactions, determines which accounts
those transactions will be booked to, gathers and organizes the
client’s records for return preparation, or prepares schedules or
other supporting documents that are relied upon by the return
preparer.
b.
Junior Return Preparation. In larger engagements, junior
accountants serve to assist in the preparation of a tax return but
may not be the actual preparer who signs the return.
c.
Return Preparer. The accountant who actually signs the return as
preparer is the person that the IRS will first assume has the most
knowledge about how the return was prepared. In many
engagements, there may actually be others with more knowledge
about the preparation of the return and the sources of the numbers
that appear on the return.
d.
Investigator. An investigative accountant often provides critical
support in an eggshell audit and in the subsequent criminal case by
17
reviewing books and records, organizing the documents,
developing alternative approaches to issues, and computing
different tax consequences based on those alternative approaches.
2.
C.
1393345.1
e.
Client Representative.
Accountants often handle the
examinations themselves, but in eggshell audits, this can be
potentially dangerous. More often, an accountant will serve as a
“front” for an attorney, while the attorney stays in the background
to provide strategy and advice regarding the responses to sensitive
issues in the examination.
f.
Trial Assistant. Once a case reaches the stage of trial, the
attorney may need the assistance of an accountant to help analyze
the evidence presented by the government and attack the positions
taken by the testifying government agents.
g.
Testifying Expert. In most criminal trials, the taxpayer needs an
accounting expert to testify in order to rebut the government’s
position or present some other affirmative defense.
Protect Communications and Work Product. In an eggshell audit, the
accountant who previously communicated with the taxpayer often should
not be the one to represent the taxpayer in the examination. A thorough
analysis of the knowledge held by the taxpayer’s accountant is necessary
to prevent any unnecessary exposure of sensitive issues, avoid the need for
the representative to invoke the tax practitioner privilege and thereby alert
the agent to the sensitive issue, and also to protect any work product that
may exist.
a.
Sometimes the return preparer may be concerned about his or her
own personal exposure to penalties or prosecution, which
obviously impacts the decision as to who will handle the
examination.
b.
Segregating the knowledge of the return preparer and using an
examination representative who has limited knowledge of the
sensitive issues may often be necessary to prevent misleading the
agent or exposing the sensitive issues.
Accountant/Client Privilege Issues.
1.
New Protection for Certain Communications. Section 7525(a)(1)
extends the same common law protection of confidentiality to any
communication between a taxpayer and any “federally authorized tax
practitioner” that would have been privileged if it were a communication
between a taxpayer and an attorney.
2.
Matters Covered. The new privilege may be asserted only in:
18
3.
a.
Non-criminal tax matters before the Internal Revenue Service; and
b.
Any non-criminal tax proceeding in federal court brought by or
against the United States.
Federally Authorized Tax Practitioner. The term “federally authorized
tax practitioner” means any individual who is authorized to practice before
the IRS if such practice is subject to federal regulation under 31 U.S.C.
§ 330. In other words, the phrase includes CPAs, enrolled agents, and
enrolled actuaries.
a.
Tax Advice. The term “tax advice” means any advice given
within the scope of the individual’s authority to practice before the
IRS. In other words, it includes tax advice and tax representation.
4.
Effective Date. The privilege may be asserted only as to communications
made on or after July 22, 1998.
5.
Obvious Limitations of Section 7525.
a.
Uncovered Return Preparers. By its terms, new Section 7525 is
applicable only to communications between a taxpayer and a
“federally authorized tax practitioner.” This phrase includes
CPAs, enrolled agents, and enrolled actuaries. Other accountants,
bookkeepers, and possibly agents of otherwise qualified federally
authorized tax practitioners do not appear to be included.
b.
State, Local & Foreign Tax Matters. The phrase “tax advice” is
defined with reference to practice before the Internal Revenue
Service or in a proceeding before a federal court.
c.
(i)
Query: Are state and foreign tax matters automatically
excluded by this definition?
(ii)
The new provisions apparently do not cover state court
foreclosure actions where one issue might be the priority of
the federal tax lien.
Non-Criminal Only. The extension of privilege to “any noncriminal tax proceeding in Federal Court brought by or against the
United States” in Section 7525(a)(2)(B) was inserted by the Senate
(or the conference committee) and was designed to be broader than
the House version, which had only covered tax litigation.
(i)
Criminal Matters Excluded. The statute appears to be
specifically inapplicable in criminal proceedings before the
Internal Revenue Service and in criminal proceedings in a
Federal Court. (However, see the discussion below
19
1393345.1
regarding the dividing line between civil and criminal
matters.)
d.
(ii)
Bankruptcy Covered? Bankruptcy is not a non-criminal
federal court matter “by or against the United States” until
an adversary proceeding is filed. Does the new provision
cover all bankruptcy cases in which the United States is a
party, or just cases in which a determination of tax liability
is involved?
(iii)
Result. As a practical matter, the §7525 privilege
disappears when a client client’s freedom is in jeopardy—
in the criminal tax arena.
Tax Shelters. The American Jobs Creation Act of 2004, Pub. L.
No. 108–357, § 813(a), 118 Stat. 1418, 1581, modified §7525 to
eliminate the privilege for all written communications between a
practitioner and any person “in connection with the promotion of
the direct or indirect participation of the person in any tax shelter
(as defined in section 6662(d)(2)(C)(ii)).”
(i)
Ambiguous At Best. Although reference is made to
Section 6662, the definition of tax shelter in that section is
far from precise.
(ii)
Shelter Definition. A tax shelter is defined under Section
6662 as any partnership, entity or plan “a significant
purpose of which is the avoidance or evasion of income
tax.” The Taxpayer Relief Act of 1997 replaced the words
“the principal purpose” with the words “a significant
purpose.” Section 6662(d)(2)(C)(iii).
(iii)
Narrow Interpretation? In the original debate over the
adoption of §7525, Senator Connie Mack stated that
Congress intended for the IRS to narrowly interpret the
exception from the privilege for communications regarding
tax shelters. Query whether that has any meaning after the
JOBS Act.
(iv)
Effective Date.
The new limitation applies to
communications made on or after October 22, 2004.
Before that date, the tax shelter limitation on the taxpractitioner
privilege
was
limited
to
written
communications in connection with corporate tax shelters.
See Juan F. Vasquez, Jr. & Peter A. Lowy, The Scope of the
Corporate Tax Shelter Exception to the § 7525 Tax
20
1393345.1
Practitioner Privilege, J. Tax Prac. & Proc., Aug./Sept.
2004.
e.
6.
Tax Return Preparation Not Covered. The privilege for tax
advice is the same as if the professional were an attorney. This
means, among other things, that the privilege does not attach to
the preparation of tax returns or to other areas where a
communication ordinarily would not be privileged if made to an
attorney. Federal courts have denied attorney-client privilege to
tax return preparation work on different grounds.
(i)
Not Legal Advice? Some courts have held that the
preparation of tax returns is not legal advice. See United
States v. Davis, 636 F.2d 1028 (5th Cir. Unit A), cert
denied, 454 U.S. 862 (1981); United States v. Gurtner, 474
F.2d 297 (9th Cir. 1973); Canaday v. United States, 354
F.2d 849 (8th Cir. 1966). In re Grand Jury Investigation
(Schroeder), 842 F.2d 1223 (11th Cir. 1987).
(ii)
Not Confidential? Some courts acknowledge an element
of legal advice in the preparation of returns, but deny
privilege based on a lack of expectation of confidentiality
or a waiver. United States v. Lawless, 709 F.2d 485 (7th
Cir. 1983) (no expectation of confidentiality in information
to be included on return); Dorokee Co. v. United States,
697 F.2d 277 (10th Cir. 1983); United States v. Cote, 456
F.2d 142 (8th Cir. 1972) (disclosure waives privilege not
only as to disclosed data but also as to details underlying
the information on the return); United States v. El Paso
Co., 682 F.2d 530 (5th Cir. 1982), cert. denied, 466 U.S.
944 (1984) (waiver by inclusion on return).
(iii)
Contrary Position. But see Colton v. United States, 306
F.2d 633, 637 (2d Cir. 1962) (“There can, of course, be no
question that the giving of tax advice and the preparation of
tax returns * * * are basically matters sufficiently within
the professional competence of an attorney to make them
prima facie subject to the attorney-client privilege.”) United
States v. Abrahams, 90-1 U.S.T.C. §50,310 (9th Cir. 1990)
(“Although communications made solely for tax
preparation are not privileged, communications made to
acquire legal advice about what to claim on tax returns may
be privileged.”)
Civil v. Criminal. The inapplicability of the privilege in “criminal
matters” will require a determination of when an otherwise civil tax
dispute becomes a criminal matter. Often an agent has made a
21
1393345.1
determination to refer a matter to the Criminal Investigation Division but
continues to work on the case until formal referral is made. A practitioner
advising a client in this circumstance will be at risk to reveal
communications that occur after the matter becomes “criminal.”
7.
D.
a.
The LaSalle National Bank Issue Again. Special agents have
duties to investigate both criminal and civil liabilities. Is it
automatically a criminal matter if a special agent is involved? The
Supreme Court defined in LaSalle National Bank that a matter is
not criminal until there has been an institutional referral to the
Department of Justice, which standard was adopted in Code
§ 7602(c). United States v. LaSalle National Bank, 437 U.S. 298
(1978).
b.
Reinstatement of Privilege? Assume a criminal investigation was
commenced, the practitioner was forced to disgorge otherwise
privileged information, and now the criminal case has been killed.
Does the privilege reinstate itself?
Business Advice v. Tax Advice. Section 7525 is also limited to “tax
advice.” The “gray area” dividing business advice and tax advice is still
being debated by the courts in traditional attorney-client cases. Further
confusion likely will develop in interpreting this new statute.
Recommendations to Seek to Bolster Kovel Accountant Privileges. Certain
safeguards should be followed to ensure that the attorney-client privilege or the
work product doctrine applies as fully as possible.
1.
Burden. The party asserting the attorney-client or work product privilege
has the burden of sustaining the privilege.
a.
That burden cannot be discharged by a blanket claim of privilege.
b.
Instead, the claimant must produce sufficient evidence to establish
privilege for each item for which it is claimed.
2.
Documentation. Take care to document the commencement of the
attorney-client privilege. A well-thought-out engagement letter certainly
will help.
3.
Avoid Multiple Roles. To the extent possible, try to avoid situations in
which a professional must fulfill multiple roles.
a.
Where finances or other circumstances make multiple
professionals impractical, try to delineate when a professional acts
as counsel (or as an adjunct to counsel) by having a separate
engagement letter.
22
1393345.1
b.
E.
4.
Execute a Contract. Use a Kovel contract between the attorney and the
consultant. Make sure it says that the consultant is being retained to assist
the attorney’s rendition of legal services to the client, that the consultant
will work under the direction and control of the attorney, that the
consultant is expected to keep all information obtained from the client or
his agents confidential, and that all consultant workpapers are the property
of the attorney.
5.
Protect Work Product. Document the commencement of the “specific
claim” which gives rise to a work product privilege. Actual litigation need
not have commenced, nor need an attorney have been hired.
Cooperation.
1.
2.
1393345.1
If the issue is particularly sensitive, the consultant and examination
representative should be different from the return preparer.
The Dilemma. Experienced criminal tax attorneys often conclude that the
taxpayer’s actions can be explained as non-criminal. The dilemma is
whether that explanation will kill any possibility of criminal investigation
or actually result in a criminal referral.
a.
Cooperation sometimes convinces a revenue agent not to refer a
case, but if the agent finds strong evidence of fraud, the case is
likely to be referred regardless of whether or not the taxpayer
cooperated.
b.
Representations made to a revenue agent may be used against the
client at trial, even if the representations were made by the
taxpayer’s agent.
c.
A complete refusal to cooperate may result in a fraud referral that
was otherwise preventable.
d.
The decision as to whether to cooperate often depends upon the
amount of investigation and information available to the taxpayer’s
representative. Generally, the extent of cooperation will be
determined on a factual basis during the course of the audit,
depending upon the questions asked and the documents requested.
e.
If documentary evidence will be easily obtained by the revenue
agent to show an understatement of tax, admission of the
understatement with an explanation may be the appropriate
strategy to demonstrate a lack of willfulness and the absence of an
intent to defraud.
Burden of Proof Considerations. The 1998 IRS Restructuring and
Reform Act added Section 7491 to the Code, which ostensibly shifts the
23
burden of proof to the IRS in tax litigation matters. Tax practitioners must
explain this provision in detail to their clients and caution the clients that
this new code section provides little or no additional reason to cooperate
with revenue agents.
3.
a.
The burden of production remains on the taxpayer. The statute
requires that the taxpayer introduce “credible evidence” with
respect to a factual issue in order to shift the burden of proof to the
government.
b.
The burden of proof does not relieve the taxpayer from
substantiation requirements for those sections of the Code, such as
§ 274(b), which demand substantiation.
c.
The burden of proof remains on the taxpayer unless the taxpayer
can meet the net worth guidelines established in Section
7430(c)(4)(A)(ii).
d.
The taxpayer must have cooperated with reasonable requests by
the government for witnesses, information, documents, meetings
and interviews.
e.
Many commentators have indicated that this new burden of proof
provision will force taxpayers to weigh the benefits obtained by
cooperating with the IRS with the risk that they will lose the shift
of the burden of proof if they do not cooperate.
f.
However, the shift of the burden of proof embodied in § 7491 is
really just a shift in the burden of persuasion.
(i)
Since the taxpayer retains the burden of production, that
part of the burden of proof remains on the taxpayer.
(ii)
The taxpayer’s actual gain from § 7491 is simply that the
taxpayer will prevail in those cases where the court finds
the evidence to be of equal weight for both the taxpayer
and the government.
(iii)
Because there are so few cases in which courts find the
evidence to be so equally weighted that the decisions turn
on the burden of persuasion, the new code section which
ostensibly shifts the burden of proof actually creates no
new incentive on the part of taxpayers to cooperate with
IRS investigations.
Non-Cooperation as a Badge of Fraud. Taxpayer non-cooperation is
viewed by revenue agents as an indication of fraud. I.R.M. § 25.1.2.2.
24
1393345.1
4.
F.
a.
Thus, cooperation may lower the likelihood of a fraud referral if
the IRS has no facts to support the willfulness of the taxpayer.
b.
Cooperation also deprives the government of a common trial tactic
by preventing an argument that the taxpayer’s behavior during the
investigation was consistent with willful violation of the Code or
an attempt to prevent discovery of the taxpayer’s violations.
Sentencing Guidelines Considerations. In cases where a defendant will
be forced to plead guilty to criminal violations of the tax laws, cooperation
at an early stage can demonstrate extraordinary “acceptance of
responsibility,” which can result in reductions of sentences pursuant to the
United States Sentencing Guidelines.
a.
Extraordinary acceptance of responsibility sometimes can be a
grounds for a downward departure under the guidelines beyond the
points provided for normal acceptance of responsibility.
b.
Cooperation also permits taxpayer’s counsel to have more input in
the calculation of the criminal tax loss. If the revenue agent and
special agent determine a high tax loss before the taxpayer begins
to cooperate with the investigation, this can ultimately damage the
ability to reach a plea bargain because the probation office might
obtain access to those initial, higher calculations.
Access to the Taxpayer.
1.
2.
Resisting the Taxpayer Interview. In eggshell audits, it is critical to
protect the taxpayer from an interview, because proof of the taxpayer’s
intent is the most difficult proof for the government to obtain without
access to the taxpayer.
a.
Section 7521(c) gives the taxpayer the right to be represented
before the Internal Revenue Service and not to appear for
questioning unless an administrative summons is served upon the
taxpayer.
b.
In some districts, the use of revenue agents summons has become
routine. In other districts, a summons will be issued routinely if a
personal interview is refused or fraud is suspected.
Controlling the Taxpayer Interview. Many taxpayer representatives
follow the practice of asking to defer any taxpayer interview until a point
late in the examination.
a.
1393345.1
By deferring the interview, the interview becomes less of a fishing
expedition and more of a specific inquiry into items that have been
discovered during the examination.
25
3.
4.
G.
Many agents will provide an outline of topics to be discussed at the
interview so that the taxpayer can be prepared to address those
issues.
c.
The place of the interview also should be controlled, as it can be
awkward for the examiner to interview the taxpayer at his place of
business. Frequently these interviews take place at the attorney’s
office. See, however, Treas. Reg. § 301.7605-1 concerning the
place of examination.
d.
The taxpayer must be prepared thoroughly in advance of the
examination. The taxpayer must be cautioned that lies could
further compound the problem. In essence, the taxpayer must not
be permitted to make admissions or give explanations that are
inconsistent with the explanation that defense counsel knows must
be given for the events.
Refusing the Taxpayer Interview. In many eggshell audits, the sensitive
nature of the transactions prevents any taxpayer interview. If the taxpayer
is summonsed, then the Fifth Amendment privilege must be invoked.
a.
Invocation of the privilege against self-incrimination generally
increases the odds of a fraud referral.
b.
Often it is better to take the Fifth Amendment and force the
government to prove its case rather than handing the government
an explanation on the taxpayer’s silver platter.
Economic Reality Audits. In recent years, it has become the vogue for
the examination division to investigate the financial status of a taxpayer in
order to determine whether there is a likelihood of unreported income in
appropriate cases.
a.
The IRS Restructuring and Reform Act prohibits the IRS from
using financial status or economic reality examination techniques
unless the examining agent has a reasonable indication that there is
a likelihood of unreported income. Section 7602(e).
b.
The new code section provides no consequences to the IRS if the
provision is violated. Thus, the taxpayer’s right to avoid undue
investigation of his financial affairs may be a right without a
remedy.
Records Control.
1.
1393345.1
b.
Shadow Investigation. In many respects, the taxpayer’s representative
must conduct a “shadow examination” in order to analyze the information
made available to the revenue agent.
26
2.
Playing Catch-Up. If the attorney enters the case after the civil
examination has been in progress for a while, it is important to obtain
copies of the documents that have been produced.
a.
A Freedom of Information Act (FOIA) request should be
considered to determine what information has already been
obtained by the IRS.
b.
Copies of the original returns also should be obtained rather than
relying upon the taxpayer’s or the preparer’s retained copies.
Frequently, the agent will produce them upon request, or a FOIA
request or Form 4056 can be filed to obtain copies of the original
returns.
c.
Also consider obtaining a copy of the transcript in order to
determine the date the IRS claims the return was received, the
payments recorded on the account, and any prior examination or
adjustments.
3.
Third Party Documents. The taxpayer’s representative always should
arrange to review and copy any documents that third parties provide to the
revenue agent. Moreover, if the taxpayer’s records have been left with
third parties, for example, the return preparer, the representative should
have those copies returned to the taxpayer in order to evaluate whether the
Fifth Amendment privilege may prevent production of those documents.
4.
Follow the Leads. The material requested by the revenue agent often
provides a clue as to the direction of the investigation. If the agent can use
the documents to prepare an indirect income analysis through the net
worth method or the bank deposit method, the taxpayer’s representative
obviously should perform the same sort of investigation.
5.
Protect Privileged Documents. The act of production privilege under the
Fifth Amendment may protect an individual from producing personal
records if that production will have testimonial aspects, such as proving
the existence, possession and authenticity of the documents. United States
v. Doe, 465 U.S. 605 (1984). However, a corporation has no privilege
against self-incrimination, so a corporate custodian must produce the
records, although the act of production cannot be used against the
custodian as an individual. Braswell v. United States, 487 U.S. 99 (1988).
Footnote 11 of Braswell left open the question of whether the agency
rationale supports compelling a custodian to produce corporate records if
the custodian might be able to show he is the sole employee or officer of
the corporation and that the jury would inevitably conclude that he
produced the records. Id. at 118.
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H.
Notice of Third Party Contacts.
1.
2.
V.
Section 7602(c). Section 7602(c) requires reasonable notice in advance to
the taxpayer before the IRS may contact third parties in connection with
the taxpayer’s examination or collection matter.
a.
The provision does not apply to criminal tax matters, jeopardy
collection matters, or if the government determines that disclosure
may involve reprisal against some person.
b.
The IRS must also periodically provide the taxpayer a record of
those persons previously contacted by the IRS.
No Remedy. This section provides the taxpayer with another right but no
remedy, as the Code provides no penalty to the IRS if it should fail to give
the required notice. There is also no judicial supervision of the IRS’s
determination that good cause exists to permit a third party contact
without prior notice.
HANDLING THE CURRENT YEAR OR DELINQUENT RETURNS.
A.
Consider Voluntary Disclosure.
1.
2.
Voluntary Disclosure Practice. The current IRS voluntary disclosure
policy is found at I.R.M. § 9.5.11.9.
a.
The policy requires that a disclosure be timely, complete, truthful,
and that the taxpayer evidence a willingness to cooperate with the
IRS in determining the correct tax liability.
b.
United States v. Tenzer, 950 F. Supp. 554 (S.D.N.Y. 1996), rev’d,
127 F.3d 222 (2d Cir. 1997) holds that in order to take advantage
of the voluntary disclosure program, the taxpayer must either make
full payment of all outstanding tax liabilities or make a good faith
effort to enter a payment arrangement with the IRS.
Foreign Bank Accounts.
In March of 2009 the IRS announced a new voluntary disclosure initiative.
For a six month time period, if taxpayers voluntarily disclose their foreign
bank accounts, and otherwise qualify under the IRS’s voluntary disclosure
program, penalties are reduced from 50% to between 20% and 5%. This
initiative, however, expired on October 15, 2009
3.
Solicitation Policy.
a.
The IRS Chief Counsel’s Directives Manual indicates that, absent
unusual circumstances, taxpayers should not be prosecuted for
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failure to file returns that have been solicited by the IRS and
received prior to the taxpayer being contacted by the criminal
investigation division. C.C.D.M. § (31)360(2) (b)(2).
b.
B.
If a collection officer or revenue agent solicits a delinquent return,
a complete and truthful return normally should be prepared as
rapidly as possible in order to prevent a failure to file prosecution.
Filing The Current Year Return.
1.
Tax Returns Filed During an Investigation. In a criminal tax
investigation, the subject of the investigation faces a host of problems
resulting from the requirement that he file current tax returns with the very
agency conducting the investigation. The filing of a current year tax
return presents problems because it will often require admissions of facts
relevant to the criminal investigation.
a.
Exculpatory Evidence. In some circuits, the taxpayer may use a
current year or amended return to his advantage, offering evidence
of the filing of amended tax returns and the payment of tax to show
lack of willfulness. See, e.g., United States v. Rischard, 471 F.2d
105 (8th Cir. 1973), and Hill v. United States, 363 F.2d 176 (5th
Cir. 1966).
b.
Admissions.
Statements made in a tax return constitute
“admissions.” See, e.g., United States v. Dinnell, 428 F. Supp.
205, 208 (D. Ariz. 1977), aff’d without opinion, 568 F.2d 779 (9th
Cir. 1978); United States v. Hornstein, 176 F.2d 217, 220 (7th Cir.
1949).
c.
Use of the Returns by CID. Ordinarily, tax returns and return
information are required by statute to be kept confidential. I.R.C.
§ 6103(a). However, returns or return information may be
disclosed for use in criminal investigations pursuant to §§ 6103(h)
and (i)(1)-(2).
2.
Extensions. In most circumstances, a taxpayer under investigation should
avail himself of all of the filing extensions provided by law. This will, at a
minimum, have the effect of requiring the agent to continue his
examination without benefit of admissions made in the return and provide
the practitioner with additional time to focus on and address problem
areas.
3.
Asserting the Fifth Amendment Privilege on Tax Returns. Although a
taxpayer may not make a blanket claim of Fifth Amendment privilege on a
tax return, the taxpayer may make a specific claim of such privilege as to
the source of income, at least in circumstances where the source of income
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is illegal and disclosure on the return would be potentially incriminating.
See, e.g., Garner v. United States, 424 U.S. 648 (1976); United States v.
Sullivan, 274 U.S. 259 (1927).
a.
Invoking the Privilege as to Amount of Income. The question is
much more difficult as to whether the privilege may apply not just
to the source, but also to the amount of an item of income. There
is ample authority for the proposition that a taxpayer may claim the
Fifth Amendment as to the amount of the taxpayer’s income, but
the issue is less than perfectly clear.
(i)
The Sullivan case. The Supreme Court stated the
following in United States v. Sullivan with respect to
claiming the Fifth Amendment as to the amount of income:
It would be an extreme if not an extravagant
application of the 5th Amendment to say
that it authorized a man to refuse to state the
amount of his income because it had been
made in crime. But if the defendant desired
to test that or any other point he should have
tested it in return so that it could be passed
upon.
United States v. Sullivan, 274 U.S. at 263-264. This
statement acknowledges the possibility that the privilege
could be claimed to excuse reporting the amount of income
earned if the amount would disclose the criminal activities
that had produced the income. However, many courts have
read this as implying that the amount can never be
privileged. See, e.g., United States v. Booher, 641 F.2d
218, 220 n.2 (5th Cir. 1981); United States v. Mirelez, 496
F.2d 915, 917 (5th Cir.), cert. denied, 419 U.S. 1069
(1974).
(ii)
Marchetti and Grosso. In Marchetti v. United States, 390
U.S. 39 (1968) and Grosso v. United States, 390 U.S. 62
(1968), the Supreme Court held that the Fifth Amendment
privilege could justify the failure to file wagering excise tax
returns or to pay the tax, under circumstances where simply
filing the return or paying the tax would be incriminating.
Because these opinions approve a complete refusal to file a
return and pay the tax and where the very filing of the
return is incriminating, it should follow that a taxpayer
may, in proper circumstances, make a selective refusal to
supply an amount of income and to pay the tax on that
item. Consistent with this analysis, several courts of appeal
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have indicated that under certain circumstances the amount
of income could be subject to the privilege.
b.
Distinctions Between Tax and Non-Tax Violations. Even
assuming that the Fifth Amendment privilege could be claimed as
to the amount of an item of income, the question arises whether the
privilege applies where the taxpayer’s concern is potential
incrimination with respect to tax crimes, as opposed to non-tax
crimes.
(i)
In Garner v. United States, 424 U.S. 648, 650 n.3 (1976),
the Court specifically limited its holding to Fifth
Amendment claims based on fear of non-tax crimes, stating
“the claims of privilege we consider here are only those
justified by a fear of self-incrimination other than under the
tax laws.” (Emphasis added). As the Ninth Circuit
recognized in United States v. Carlson, 617 F.2d 518 (9th
Cir.), cert. denied, 449 U.S. 1010 (1980), the Supreme
Court meant to leave open the question of whether the
privilege could extend to concern over tax crimes. The Tax
Court however, read this to mean that the privilege does not
apply in such circumstances. Conforte v. Commissioner,
74 T.C. 1160, 1195-1995 (1980), aff’d and rev’d on other
issues, 692 F.2d 587 (9th Cir. 1982).
(ii)
The cases cited by the Tax Court, however, do not support
its conclusion. In Mackey v. United States, 401 U.S. 667
(1971), the defendant had filed wagering excise tax returns
reflecting income from an illegal gambling business. The
government subsequently prosecuted and convicted him for
attempted evasion of income tax, relying on the excise tax
returns, which showed greater income than was reported
for income tax purposes. Following the decisions in
Marchetti and Grosso, the defendant moved to vacate his
sentence, arguing that since he had a Fifth Amendment
privilege not to file the returns in question, but filed them
under threat of prosecution (Code Section 7203), the
government should not have been permitted to use the
returns against him as evidence at the trial. The case
resulted in several opinions. The lead opinion, written by
Justice White, and concurred in by the Chief Justice,
Justice Stewart and Justice Blackmun, held that Marchetti
and Grosso did not apply retroactively to the case. In a
concurring opinion, Justices Brennan and Marshall held
that, although the Fifth Amendment may have protected
Mackey had the government sought to prosecute him for
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gambling crimes, the privilege afforded him no protection
against prosecution for tax crimes.
c.
d.
Ensuring a “Fifth Amendment Return” Qualifies as a “Tax
Return”. Even if the contemplated claim of the Fifth Amendment
privilege is determined to be invalid, that would not necessarily
affect the qualification of the taxpayer’s Form 1040 as a “tax
return.” Under case law, a return need not be absolutely complete
to qualify as a return, but need only be “substantially” complete.
See, e.g., United States v. Vaughn, 589 F.Supp. 1528, 1531 (W.D.
La. 1984). In the context of a complex return reflecting large
amounts of income, the omission of a relatively small item of
income would not appear to make the return not “substantially”
correct.
(i)
On the other hand, the filing of an improper “Fifth
Amendment” return may subject a taxpayer to the
“frivolous return” penalty of § 6702. See, e.g., Brennan v.
Commissioner, 752 F.2d 187 (6th Cir. 1984); Baskin v.
United States, 738 F.2d 975 (8th Cir. 1984).
(ii)
Worse yet, the absence of good faith in making the Fifth
Amendment claim on a return could result in criminal
prosecution for willful failure to file a return under 26
U.S.C. § 7203 or for some other tax offense. See, e.g.,
United States v. Jordan, 508 F.2d 750 (7th Cir.), cert.
denied, 423 U.S. 842 (1975).
Conclusions About “Fifth Amendment Returns”.
There
appears at least a reasonably supportable position that, in certain
circumstances, taxpayers may claim the Fifth Amendment
privilege in lieu of reporting the source and amount of a particular
portion of income on his tax return. Although several cases have
held that the Fifth may not be claimed as to the amount of income,
those cases all involved simple protester returns and the
discussions therein were pure dicta.
(i)
Timeliness Requirement. In light of cases such as
Garner, taxpayers must assert the privilege at the time the
return is to be filed, or they will almost certainly lose it.
(ii)
Supporting Statements. If it is determined that the
privilege should be claimed, the taxpayer should attach a
statement that must be carefully reviewed and drafted
according to the specifics of the case.
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4.
5.
Cash Bonds. A deposit in the nature of a cash bond will stop the running
of interest on deficiencies. The procedures for making deposits in the
nature of a cash bond are described in Rev. Proc. 84-58, 84-2 C.B. 501.
a.
In some cases, the taxpayer will have little to lose in making a
deposit in the nature of a cash bond if funds are available to do so.
b.
The deposit does not constitute an admission that additional taxes
are owed.
c.
By the same token, the deposit may be used at some point in the
future, either before a judge or a jury, as evidence of the taxpayer’s
good faith to comply with his responsibilities.
Payments v. Deposits. If a taxpayer remits an amount along with a Fifth
Amendment return to be applied to a liability when a qualifying return for
the year can be filed, is the remittance a payment or a deposit in the nature
of a cash bond? This can be an important issue.
a.
Three Certain Rules. There are three rules: If the remittance is a
payment, a claim for refund must be filed. I.R.C. § 6511(b)(1). In
addition, the claim for refund must be filed within three years from
the time the return for the year is filed, or within two years from
the date payment of the tax was made, whichever is later. I.R.C.
§ 6511(a). Finally, the amount that can be refunded is limited to
the amount paid within the three year from filing period, or within
the prior two years. I.R.C. § 6511(b)(2)(A) and (B).
b.
Cash Bond Procedures. Rules for deposits in the nature of a cash
bond for purposes of determining interest and the existence of a
deficiency are described in Rev. Proc. 84-58, § 4.02.
(i)
A deposit in the nature of a cash bond is a remittance made
(i) before a notice of deficiency is mailed, and (ii)
designated by the taxpayer in writing as a deposit in the
nature of a cash bond.
(ii)
An undesignated remittance is any remittance made by the
taxpayer before the IRS has made a proposed determination
of additional tax. Rev. Proc. 84-58, § 4.04.
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(iii)
c.
Undesignated remittances:
(a)
are treated as deposits
(b)
are not subject to a claim for refund because they
are not considered overpayments
(c)
do not draw interest, and
(d)
will be returned to the taxpayer on request assuming
no jeopardy in collection and no other outstanding
liability.
Facts and Circumstances Test. The Tax Court has held that a
remittance with an automatic extension was not a payment
triggering the statute of limitations on refund. Risman v.
Commissioner, 100 T.C. 191 (1993). The Tax Court applied a
“facts and circumstances” test to determine whether a remittance is
a payment or deposit, including examination of the following
factors:
(i)
When the tax liability is defined;
(ii)
The taxpayer’s intent when remitting; and
(iii)
IRS treatment of the remittance upon receipt.
Ewing v. United States, 914 F.2d 499, 503 (4th Cir. 1990). The
Fourth Circuit also applied a facts and circumstances test in Ameel
v. United States, 426 F.2d 1270, 1273 (6th Cir. 1970). The Court
found that the remittance in Risman was a deposit, not a payment,
because “the [taxpayer’s] $25,000 remittance was made by [him]
arbitrarily, in an amount which had no good faith relationship to
[his] actual joint federal income tax liability for 1981.” Thus, to
distinguish a deposit from a payment, the amount remitted cannot
have a good faith relationship to the actual liability, and the
taxpayer cannot have intended to satisfy that liability.
d.
A Different View. Some circuit courts disagree with the Tax
Court’s decision in Risman. See, Gabelman v. Commissioner, 86
F.3d 609 (6th Cir. 1996) (estimated payment with extension treated
as payment); see also Estate of Zeier v. United States, 80 F.3d
1360 (9th Cir. 1996) (remittance with tentative estate tax return
considered a payment); Chemical Bank New York Trust Co. v.
United States, 275 F.Supp. 26, 30 (S.D.N.Y.), aff’d, 386 F.2d 995
(2d Cir. 1967) (remittances as estimated tax payments are subject
to limitations under § 6511(b)(2)(A)).
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